Lumber Liquidators (LL) has faced its fair share of problems over the years, but its main failing is management's inability to grow same store sales. Management has talked many times about the various levers they can pull and are pulling in order to return the company to profitability, but the only one which really matters and which they have been unable to pull, has been increasing same store sales. And this is why LL shares are trading at $11 per share. This is why shares have fallen 70% in the last 20 months. This is why investors are so angry that the Board has been obliged to hire a shareholder advisory firm to beg shareholders to ratify some unfriendly shareholder proposals. Frankly, if the company was showing same stores sales growth (SSS growth) in the 4% to 5% range, I wouldn't be writing this article right now and the company would be in a very different position.
Everything But Sales
The following quote is directly from Lumber Liquidators' 2018 Annual Report, on page 4:
The overall flooring industry has grown at a compound annual growth rate of 5.4% from 2012 through 2017. Over the same period, hardwood, laminate and vinyl flooring sales, including the cost of installation grew at a compound annual growth rate of 8.3%. [Source]
For 2017, Lumber Liquidators same store sales grew 5.4%, which was a respectable gain, after several tumultuous years of negative growth. But the healthy sales gains were temporary. In 2018, SSS only increased 2.6%. For 2019, management has guided for SSS to be" flat to up in the low-single digits." So far in the first quarter of 2019, SSS actually dropped 0.8%. These numbers are all well below the industry average.
Management, so far, has been focused on growing overall sales, fundamentally by adding new stores, but this strategy is flawed because all new stores come with fixed costs and reduce the liquidity position of the company by necessitating the addition of inventory. Adding new stores also cannibalizes sales at older stores, which puts an additional anchor on SSS growth. Looking at the company's income statement, we clearly see this, as the company says adjusted SG&A "increased $11.5 million in 2018, driven by a combination of higher payroll and occupancy costs, which are primarily related to the 21 new stores opened this year." Of course, management tried to mitigate this cost increase, but again, they pulled the wrong lever. They reduced advertising by $2.3 million, or 3.1%. So not only did they invest money in new stores, but these new stores also considerably increased SG&A, cannibalized sales from old stores and increased inventory commitments and then to top it all off, management reduced overall advertising by 3.1%. Is it any wonder that SSS growth fell by more than 50% from the year before?
Current management at Lumber Liquidators has a strong bias towards increasing profitability by increasing gross margin and containing costs. On October 30, 2018, CEO Dennis Knowles said "we're laser-focused on our bottom-line and believe we can drive margin expansion through careful cost management."
It's interesting to note that despite all this talk of margins, gross margins actually only increased by 30 bps in the last 2 years, rising from 35.9% in 2017, to 36.2% in 2018. More shocking, adjusted gross margins only increased 10 bps, from 35.5% to 35.6%
Management is misguided in placing so much focus on one financial metric. The fact that management's efforts have been almost completely ineffectual at moving that metric is an indication of incompetence. Using very simple arithmetic and assuming constant sales of $1.1 billion, an increase of 30bps would only increase profit by $3.3 million. That's why the company has added 33 new stores in the last 2 years but adjusted operating income has only increased from 1% in 2017 to 1.9% in 2018.
What Should Management Be Doing?
The real driver of growth and profit at Lumber Liquidators has always been SSS growth. The logic and math behind this is very simple to understand and I will present it below. And I am not talking about setting astronomically high SSS growth targets. But a simple 4% to 5% SSS growth pace per year would be more than enough to solve every problem, both internally and externally originated at this company. There are three main ways in which SSS growth can turn around the company.
1) Operating Leverage
Very simple. In order to calculate profitability at LL, we subtract the SG&A percentage from Gross Margin percentage. The remaining percentage is the Operating Margin. This figure shows us the operating profitability of the company as a percentage of total sales. As shown above, playing with the gross margin number has produced negligible results. The only other lever we have in this equation is to reduce SG&A. In this article I am not going to rehash how the company can drastically reduce net SG&A expenses (i.e. reduce bloated salaries and management bureaucracy). There is a far simpler solution for the time being. Just grow same-store sales. Assuming that SG&A costs remain the same, if the company simply grows SSS, the SGA percentage will fall, fast and considerably.
Currently Adjusted Gross Margin is 35.6% and Adjusted SG&A is 33.7%. The chart below shows what happens if total SG&A in dollar terms stays the same, but the company simply grows SSS by 4.5% per year. SG&A as a percentage of sales would fall by almost 300 bps within 2 years, more than offsetting any gross margin erosion due to tariffs or lack of execution.
This is called operating leverage. It is a basic necessity in order to profitably grow a business, but for the last 2 years, there has been very little of it at Lumber Liquidators. The above estimates assume only same store sales growth, no new store additions and a constant SG&A, which is modest, because there is room for SG&A cuts.
2) Driving Profitable Incremental Sales Dollars
An even simpler way to see how sales growth would add profits is to ignore SG&A cost altogether. The company currently has adjusted gross margins of 35.6%, meaning it earns 35.6 cents on every dollar of sales, before overhead expenses. Most of the company expenses can be considered fixed, especially when considering marginal, extra sales happening at comparable stores. In 2018, the average LL store sold $2.67 million dollars of merchandise and services. If that same store could sell 4.5% more merchandise and services in 2019, it would not significantly increase the overall costs to operate that store. But the extra $120,000 of sales would generate an extra $42,700 of gross profit (35.6%). Most of that would flow directly to the company's bottom line. Multiply that by 413 stores, and you have over $17 million of extra gross profit which would come at only a marginal cost increase. This is the power of SSS growth, presented on a very basic level. Negative SSS growth (Q1, 2019) produces the opposite effect, and results in a rapid erosion of profitability, as we have seen.
3) Market Share Gain
The flooring sales sector is very fragmented. The following pie charts, provided by Lumber Liquidators clearly show that the market is saturated with small players.
Source: LL Investor Presentations
In the past, LL was able to grow by taking market share away from these independent stores. But, in the last few years, large and fast growing competitors have entered the space. The "Big Box" (Home Improvement Stores) have gained share. Floor and Decor (FND) has entered the space and taken a large chunk of market shares. Contractors and Independent stores have lost market share. But Lumber Liquidators has not gained any market share. Clearly, it is no longer good enough for LL to be better than a mom and pop flooring retailer. They now have to beat players like Floor and Decor, Home Depot and Lowe's, which, despite their size, have been posing far stronger net sales and same store sales growth.
It's important to note that simply to maintain their market share, Lumber Liquidators has had to increase their store count from 356 at the beginning of 2015 to 393 at the end of 2017, while average store sales in that same period were actually down and are in fact still not back to average 2015 levels. That simple fact can explain almost all of the company's current financial difficulty.
I came across an interesting study, published in the Harvard Business Review over 40 years ago, but still entirely relevant and very applicable to Lumber Liquidators current situation. Here is an excerpt of the findings.
The authors discuss why market share is profitable... Specifically, as market share increases, a business is likely to have a higher profit margin, a declining purchases-to-sales ratio, a decline in marketing costs as a percentage of sales, higher quality, and higher priced products. Data also indicate that the advantages of large market share are greatest for businesses selling products that are purchased infrequently by a fragmented customer group. [Source: Harvard Business Review]
Taking the concept of SSS Growth down to the lowest common denominator, we can ignore all financial terms. In a competitive industry like flooring, fundamentally, if you are not growing your SSS, then you are losing market share. The pie is growing, but realistically, it is only so big. Imagine a high stakes poker game with Lumber Liquidators playing against Home Depot, Floor and Decor and Lowe's. If all those competitors are seeing their chip stacks grow, then logically, Lumber Liquidators' percentage of the total winnings will be decreasing. Even if new money is entering the game, if the competitors are gaining it faster than LL, then eventually LL will be squeezed out. I bring up this poker analogy because in the Q2 2017 conference call, CEO Dennis Knowles made a relevant reference:
As far as I'm concerned, execution thus far has been for table stakes. The real work of uncovering and enhancing the value of Lumber Liquidators lies ahead of us, and I'm excited to work with our team to realize those opportunities.
—Lumber Liquidators CEO Dennis Knowles
In the almost 2 years which have followed, Dennis Knowles has unfortunately not even been able to win those table stake games. Losses have mounted and the balance sheet has deteriorated. Important people have left the company and new hires have not been able to show the same levels of performance. Most importantly, in this grand poker game, competitors have been winning big hands and the blinds are only increasing.
What About Tariffs? What About Storm Headwinds? Etc...
Skeptics will likely try to drill holes in my arguments due to tariffs, and their impacts on LL's business and margins. This rebuttal is short sighted and not defensible. The 10% tariff rate which Lumber Liquidators has been forced to deal with since September 2018 and the new 25% rate which will shortly go into effect, will obviously impact the company. But it will impact all companies in the sector. In Q1 2019, Floor and Decor faced the same tariffs as Lumber Liquidators, but FND posted SSS growth of 3.1% while LL posted SSS growth of -0.8%. In that same environment, FND increased gross margin 120 bps, while LL saw gross margin fall 110 bps. Both companies are facing similar macroeconomic issues, but their financials are going in completely opposite directions.
I also find it interesting that FND blamed most of its slow SSS growth on headwinds from last year's Hurricane Harvey. FND stated that if not for these tough comparables at stores located in the Houston market, SSS growth would have been 7.1%. Recall that in Q1 2018, FND posted a large "400 basis points comp benefit due to the demand from Hurricane Harvey."
Meanwhile, Lumber Liquidators similarly decided to implicate hurricane headwinds for their poor sales guidance, blaming "tougher comparisons against the Hurricane Harvey storm benefited markets in 2018." The only problem is that astute readers might recall that in the beginning of 2018, Lumber Liquidators management said that the company actually received very little benefit from Hurricane Harvey reconstruction.
February 27, 2018:
We only have 8 to 10 stores depending on where you draw the storm ring around that. So, it's a very small part of our business and just didn't have that strong contribution."
—Former Lumber liquidators CFO Martin Agard
May 1, 2018:
We still see a bit of strength in the South from that in Texas. We never really saw much in Florida. Maybe there'll be a slow steady tailwind there. The pickups we saw in the Texas, Houston market are diminishing. They're not quite gone yet, but there were still a little tailwind from that one.
—Lumber Liquidators CEO Dennis Knowles
Put very simply, Lumber liquidators is claiming a same store sales growth headwind, when it actually never really benefited from a tailwind.
Again, the sluggish same store sales growth and poor same store sales guidance is not based on macroeconomic factors. It's company specific. More accurately, it's management-specific.
Management at Lumber Liquidators has been trying to increase the profitability of the company by focusing on increasing gross margins. During the last two years this "strategy" has had negligible results. It would have been far easier and more effective if those same efforts had been placed on simply growing same store sales. The company would have benefited from increased market share and sales leverage to reduce SG&A as a percentage of sales. Going forward, the company has blamed week guidance and poor performance on macroeconomic factors. But competitors such as Floor and Decor are facing these exact same factors and are seemingly having very little difficulty surmounting them.
The fault for this divergence of performance must fall on the shoulders of Lumber Liquidators' management, specifically, the executive team's failure to focus on relevant parts of the business needed to grow and drive profitable sales. I believe that in order to turn this company around, shareholders must unite and elect a new Board of Directors.
I have formed the Lumber Liquidators Value Committee, composed of a large and growing base of shareholders. Our goal is to gain board representation and drive positive change by strategically replacing members of the current management team. Interested shareholders can join this movement to Rebuild LL, and together we can return this company to profitability and growth, hopefully before it is too late.
Disclosure: I am/we are long LL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.